Inflation's on the rise but markets are unmoved suggesting no bank rate rise until '2017'

A sharp rise in inflation has failed to significantly alter the money market's predictions for the UK bank rate. Markets continue to suggest the Bank of England's key borrowing rate will not increase until 2017.

In fact, overnight indexed swap (OIS) charts suggest rates will fall first, in late spring, and remain at 0.25 per cent until 2015.

Swaps are financial instruments traded on money markets - they allow institutions to borrow chunks of money from each other at fixed prices. This trading gives a loose
indication of where the City believes rates are headed. The trading also influences the pricing of mortgages and savings accounts, especially fixed deals.

Crystal ball gazing: The markets now have a slightly higher outlook for interest rates compared with the August report

The Consumer Prices Index rose to 2.7 per cent in October, up from 2.2 per cent, figures from the Office of National Statistics showed yesterday.

How inflation fear - and therefore the threat of rate rises - has eased in 2012

In theory, rising inflation should spur
markets to price in a greater chance of higher future - the Bank of England can use increased
borrowing costs as a tool to ease inflationary pressure.

But the two-year swap rate only
nudged up slightly after the inflation figures were published
yesterday and was still trading at 0.66 per cent today - not far off
recent all-time lows. The five-year swap is today at 0.99 per cent.

A gloomy assessment in the Bank of England quarterly Inflation Report helped keep these swap rates pinned down. Bank Governor Sir Mervyn King warned of further economic turmoil in the years ahead.

Howard Archer, an economist at IHS Global Insight, said: 'The November quarterly Inflation Report and Sir Mervyn King’s accompanying comments suggest that the door is very much open to more quantitative easing. It also reinforces belief that the Bank of England is likely to keep interest rates at 0.50 per cent for a very long time to come.'

Vicky Redwood, an economist at Capital Economics, said: 'The forecasts make for fairly gloomy viewing – showing inflation projected to be higher in the near-term, but growth weaker.

'Indeed, the [monetary policy committee] says that the chances of a rapid recovery have receded significantly.

'Overall, then, King’s comments make us a bit more comfortable with our forecast that the committee will resume its asset purchases [QE] before long. Note that the committee paused in May, only to resume its asset purchases just two months later.

'We still expect £50bn more gilt purchases in February, possibly accompanied by an interest rate cut.'

Money market trading today implied that the bank
rate would be cut in May, return to 0.50 per cent in April 2015,
rise to 0.75 per cent in September 2017 and finally reach 1 per cent by January 2019.

This position is a huge shift from earlier this year. In spring, the market predicted a rise to 0.75 per cent by mid-2014.

The chart below shows the Bank of England's latest inflation forecast and the graphs at the foot of the page show how swap prices have moved.

The Bank expects CPI inflation to fall below the 2% target towards the end of next year

No green shoots: The gloomy outlook for the economy could see the Bank of England keep rates on hold for the long haul

How interest rate predictions have changed

When will the Bank of England make the first move? Interest rate futures on money markets give an indication of shifting sentiment. They moved dramatically in 2011. At the extremes, they pointed to an immediate rise in spring, but by the end of the year indicated 2015 for the first increase.

In the first half of 2012, forecasts modulated between a mid-2014 and late-2015 prediction.

But the worsening turmoil in the eurozone has pushed the 'first rise' prediction even further into the future and led the market to expect a cut rather than a fall. It is also due to the Bank of England's new lending plans for banks [more is explained here].

The announcement of 'QE3'in the US in mid-September for a moment made a UK rate rise slightly more likely. But the hopes of economic revival soon dissipated - and the forecast for bank rate rises moved further out.

Why 'swap rate' money markets matter to savers and borrowers

When markets move a decent amount - and the move holds - it can affect the pricing of some mortgages and savings accounts. When swaps price a rate rise to come sooner, fixed rate savings bonds tend to marginally improve in the weeks that
follow. But it also puts pressure on lenders to withdraw the best fixed mortgages.

As for using swaps as a forecast, we've consistently warned on our interest rates round-upthat they are extremely volatile and should be treated with caution - they should be used more as a guide of swinging sentiment rather than an actual prediction.

This is Money: View from the Editor

Regular readers of our interest rates round-up will know I've warned for several years that rates would remain low for a very long spell - and that readers should beware of false dawns on rising
rates; we've seen many (more on this below).

Money Editor Andrew Oxlade

We stand by that position. The prospects for the economy remain so poor [Why we face a decade of trouble] that the MPC will be nervous about
raising rates in the next few years even if inflation remains high.

Even if inflation becomes a problem, it has the option of unwinding its £375bn QE programme - selling the bonds it bought - to cool the economy before even thinking of turning to rate rises.

The trick is to keep an eye on the horizon for danger signals. The one such issue on the MPC's radar will be pay rises. If workers begin to demand much higher salaries, it would create more price pressure and possibly begin an inflationary spiral. This is unlikely but worth watching out for.

For now, there's no indication of this.
Vocalink's pay index - reliable data based on take-home wages paid into bank accounts - has been low for a year and fell sharply to 1.5% in September, from 2.3%. Official figures on pay (chart below) show rises remain modest, down at a rate of 1.7% in September (published by ONS - 17 October).

One other thing to watch out for is inflation expectations. If a fear of inflation becomes
embedded, workers will be more aggressive in demands for bigger pay rises. But they're not (see the BDO graph above) and for now, rate rises remain a very distant prospect.